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Extreme makeover

The venture capital industry is emerging from the tech-stock collapse not only slimmer and more focused but also with a number of new faces. And no less risk.

Early one warm morning this spring, W. Stephen Holmes and several of his fellow general partners at InterWest Partners welcomed a guest to their offices on Sand Hill Road, the curving, pine-tree-lined street in California's Silicon Valley that is a mecca for start-ups seeking to raise venture capital. The guest, representing a Swiss investment fund, was interested in putting money into InterWest's next venture capital fund and was dutifully making the rounds, talking to the firm's investment professionals as well as to executives of the companies in which it had invested. It was the Swiss investor's fourth visit.

"He had met in person with each of our partners here and in Dallas, talked with each of them about deal flow and quality and was ready to declare that he was interested in investing in our next fund," Holmes says. Fund IX -- conceived as a $500 million pool to be invested in 55 or so early-stage life sciences or information technology companies over the next three to four years -- had yet to be announced. InterWest wanted to delay the launch of formal fundraising until after its annual meeting with limited partners a week or so away in early April.

But the conscientious Swiss investor appeared to be too late to get in on the action. "I had to tell this new guy, despite all the due-diligence work he had done, that I couldn't guarantee him a slot in the fund," Holmes says. "Based on what our existing investors were telling me about their intentions, it looks like we may already be oversubscribed. The allocation process is going to difficult." He adds that those tough decisions will be made just before the fund closes in mid-August.

From Silicon Valley in California to Silicon Alley in New York, the bubbles bursting are from champagne as venture capital firms celebrate the imminent return of good times after three years of trauma and a fourth spent restructuring and rebuilding. The clearest sign of recovery from the collapse of technology stocks: Investors are willing to entrust billions of dollars to the very same venture capital partnerships that were generating double-digit losses not so long ago.

Responding to the groundswell of enthusiasm, more than half of the venture partnerships polled by research firm VentureOne said they plan to raise new capital this year. "It's a great time to put money to work," says one investor, who manages venture investments for wealthy individuals. "You don't want to miss out on being part of the 2004 and 2005 vintage year funds."

Indeed, industry veterans expect a rush of capital into venture funds in the second half of 2004 and into 2005. Institutional investors' venture capital allocations have slumped well below target levels, a trend exacerbated by last year's stock market run-up. Meanwhile, venture firms are eager to replenish their coffers after having been all but shut out of the market postbubble; many actually returned capital to investors because opportunities were so scant. Although a mere $2.3 billion was raised by 32 venture funds in this year's first quarter, the backlog of both demand and supply suggests to some observers that new funds could raise $30 billion over the course of 2004 and a further $15.5 billion in the first half of 2005.

The intensity of the fundraising, if not quite the magnitude, harkens back to the bubble era and attests to how venture capital has come of age as a full-blown asset class. Back in the 1980s venture fundraising hovered at around $4.2 billion a year. Then in the 1990s it crept steadily upward, from a low of $1.9 billion in 1991 to a peak of $104.9 billion in 2000. Venture capital experts expect the peak period of the current cycle to be less dramatic in volume but still comparable to the dot-com days in the pace of fundraising, the number of new funds tapping the market, the frequency with which new funds appear and the scramble to get into top funds. Venture investing in the first decade of the 21st century is a vastly changed enterprise, however, and, in the eyes of many longtime participants, a more perilous one. No longer the clumsy behemoths that so many venture funds were in the bubble era, today's streamlined funds tend to be be smaller -- and more specialized.

Indeed, so many funds now focus exclusively on life sciences that some venture capital practitioners warn of an incipient bubble in biotech. The industry, meanwhile, has developed a troubling schism: Top-tier venture firms, awash with money, are turning avid investors away, while many less renowned firms are struggling to survive. Yet as more money surges into the market -- European and U.K. institutions are also a growing presence in U.S. venture capital -- some of those funds could find their way to firms that end up investing it in an irresponsible manner, backing "me-too" firms and driving up valuations. Amid all these crosscurrents, a changing of the guard is taking place as hot emerging managers succeed an older, bubble-tainted generation that is retiring or being pushed aside.

"The venture world has definitely become a different place since 2001, and so have the relationships in it," says InterWest's Holmes. "Above all, no one wants to relearn our bubble lesson. That is driving a lot of new ways of thinking about the kinds of deals to do and the way to do them."

Today's venture capital partnerships want their funds to be much, much smaller -- they don't want to run the risk of being under such pressure to invest a giant fund that they drive deal valuations to unrealistic levels or, alternatively, embarrass themselves and alienate their own investors by having to return excess capital. Gone for good, insiders say, are the "T. rex" funds of $1 billion or more that top-tier firms routinely raised at the height of the bubble.

Technology Crossover Ventures of Palo Alto, California, for instance, brought in $900 million for its fifth fund, which closed in February, well down from the $1.7 billion the firm raised for its fourth fund in the final days of the technology bubble. This winter Baltimore-based New Enterprise Associates finished raising just over $1 billion for its 11th fund, substantially less than the $2.3 billion it gathered in 2000 for its last fund. Waltham, Massachusetts­based Charles River Ventures raised $1.2 billion in early 2001 -- then returned all but $450 million over the next two years. Its latest fund, which closed in mid-February, is only $250 million.

But because top-tier funds are now so small, many existing investors face being excluded as a growing number of large endowments and pension funds move to rebuild their venture holdings to correspond with existing allocation targets or to boost those allocations in response to a growing optimism regarding the venture industry. Those trends, industry participants worry, will ultimately create an unsatisfiable level of demand for venture capital funds in which to invest. "One of the biggest worries we have right now is that the amount of capital people want to invest greatly exceeds the number of firms that deserve to be backed," says Kevin Delbridge, a managing director of Boston-based HarbourVest Partners, a private equity firm. "This whole fundraising cycle is going to bring to the surface a bunch of issues for venture capital partnerships and their limited partners. We're going to see the top tier flooded with cash and the rest struggling to raise new funds. We're already seeing a whole new kind of relationship take shape between general partners and limited partners."

Limited partners are keeping closer tabs on general partners. Due diligence is taking longer, and offering memorandums are heftier. Moreover, institutional investors are demanding -- and getting -- more concessions on such issues as fund manager fees and the timing of distributions. Investors also are seeking greater insight into individual general partners' involvement in, and commitment to, their venture firms, over and above the traditional disclosure of their track record. This intensified scrutiny affects the funds themselves: The trend toward more specialized funds is occurring in large part because limited partners find it appealing to back funds in those areas where partners have a better track record or a greater level of expertise.

As venture firms pared back existing funds postbubble, returning uninvested capital to their limited partners, they also trimmed their own businesses, cutting loose superfluous or underperforming partners and even entire segments of their firms. In other cases, veteran venture investors, who have made their fortunes and are reluctant to commit themselves to another five to eight years of running a fund, have ceded the primary investing and fundraising roles to a new generation of general partners.

"The fundraising process is a great cleansing opportunity, a chance for firms to look at themselves closely in the mirror and ask themselves what they want to look like," says Thomas Beaudoin, a partner at Boston-based law firm Testa, Hurwitz & Thibeault, whose client list includes many venture capital firms.

For one example of the changes afoot, take a look at San Francisco­based Alta Partners, whose capital-raising pace shifted from slow to fast-forward almost overnight once partners narrowed the focus of its new fund. Launched in 1996, the firm focused its first three funds on early-stage investments in life sciences and information technology companies. But this time it really is different out there, notes Alta general partner Guy Nohra. "We started fundraising in early 2003, and it was going very, very slowly," he says. Prospective investors loved Alta's life sciences practice: The firm had invested in some 90 companies and generated healthy returns from those deals. But they were less enamored of the information technology side of the venture firm. One of the practice's founding partners, Marino Palestro, had died recently, and the other senior member, Garrett Gruener, had stepped back from active deal making to run for governor of California, leaving only junior members running the franchise. (Gruener is now back full time.) Moreover, Nohra says, "investors kept telling us they were full up to their ears; they didn't need more IT exposure."

The Alta partners withdrew from the fundraising trail in the fall to ponder their options. Late last year they decided to relaunch what had been conceived as an information technology and life sciences fund as a strictly life sciences undertaking and closed on $475 million in capital for two new funds, one (ACP IV) for early-stage and the other (Alta BioPharma Partners III) for later-stage biotechnology-related deals. "Once we focused on our core expertise, it was a slam dunk," Nohra says. "It turned out that in their hearts, the LPs preferred simpler, more specialized vehicles."

The fate of Alta's four-person information technology investing team remains to be decided. Nohra says that the business hasn't been closed down and that Alta will "probably" raise a separate IT fund "in a year or two." But venture capital insiders are betting that some of those IT specialists won't stick around to find out and instead will head out on their own to launch a new fund or join another partnership.

That's what a number of the partners at Battery Ventures did when the Wellesley, Massachusetts, firm sought to bring costs under control and prepare for a leaner, meaner future by restructuring its partnerships over the past 18 months. One of the first to be cut loose was Anthony Abate, who had specialized in the suddenly unpopular area of telecommunications deals.

"This is a hard business," says Abate, who last year joined Ironside Ventures, a tiny Waltham, Massachusetts­based firm, which began raising a $150 million IT fund -- its third -- in January. "We have 15 investors at some stage in the due diligence process, about six of which have the potential to lead the deal." Once Ironside lands a lead investor -- a respected institutional player willing to invest 10 percent or more of the capital being sought and to shoulder the time-consuming task of due diligence and negotiating the legal documents -- putting the rest of the fund together will go faster. "But it's never going to be easy for a fund our size, at our stage," Abate adds. "Most of the big players can barely take a meeting with [a smaller fund], much less spare the staff to negotiate a term sheet."

There is hope for young firms like Ironside, however, in the growing interest of institutional investors in placing money in the hands of the next generation of venture fund managers. They might prefer to invest in a fund raised by an established venture capital firm like Kleiner Perkins Caufield & Byers -- but Kleiner won't take it. Squeezed out of the top-tier funds, some of these limited partners are reluctant to invest with lower-ranking funds and instead prefer to take a chance on new partnerships (see box).

"People are on the lookout for the next great venture fund, and they know that they're not likely to find it among the so-so performers of the past few years," says Dale Meyer, a partner at Probitas Partners, a New York placement agency that helps venture firms raise capital. "They can't get into all the funds that are the surefire winners, so they're heading further afield in search of something new."

Yet even some of the hot emerging managers are turning away capital. "We could have raised several times more money than we did," says Dave Furneaux, founder and general partner of Kodiak Venture Partners, based in Waltham, Massachusetts, which finished raising $316 million for its third fund in late January. To some, Kodiak, founded in 1999, offers the allure of a new firm, untarnished by the excesses of the dot-com era. But it also has a track record: 17 of its portfolio companies have been sold or gone public.

"We're seeing a changing of the guard starting to happen," Furneaux says. "Some of the emerging managers are starting, slowly, to become name brands, and some of the older generation are starting to slide away."

The most recent round of generational change dates back to 2001, when Woodside, California­based Crosspoint Venture Partners hit the headlines after it decided against raising a new fund and walked away from $1 billion in commitments from limited partners. With founding partner John Mumford retiring, key partners departing (Bob Lisbonne, for one, moved to Matrix Partners' Menlo Park office) and junior partners consulting headhunters, Crosspoint became a model for how not to handle succession planning at a venture partnership. The firm's remaining managers continue to oversee its portfolio and invest the remainder of its last fund, but its future remains murky. The managers have said publicly in the past that they remain active investors of the fund but declined to discuss their plans with Institutional Investor.

In hopes of avoiding such a situation, limited partners are taking greater pains now to ensure that managers will stay in place for the life of a fund. "Our limited partners want to know more about how the firm works on the inside; they want to be comfortable that the partners haven't become too rich or too lazy or too arrogant to work hard," says Larry Orr, a general partner at Trinity Ventures in Menlo Park. Puzzling it out isn't always easy. "A lot of senior partners at the older funds aren't as active as they used to be, but it's not disclosed -- it's up to us to figure out who really is there and engaged in the work," says HarbourVest's Delbridge. "The first sign is that they start missing a board meeting once in a while; we look for those signals."

A few venture funds are tackling the change head-on. Kleiner Perkins, which just raised its 11th fund, is a veteran at handling succession issues: Only one of its founding partners, Brook Byers, remains active in the business 32 years after the firm's founding in 1972. The new $400 million fund, Kleiner Perkins announced, will be run by a group of managing partners, including veterans Byers and John Doerr, but not by longstanding general partner Vinod Khosla. One of the founders of Sun Microsystems, Khosla, 49, remains a partner but plans to devote more time to "personal causes." The fund also introduces some new players, including life sciences investor Risa Stack, formerly with J.P. Morgan Partners and a "principal" in Kleiner Perkins XI. Such changes make due diligence tougher for investors, says Probitas's Meyer: "It's always a pain when you have to go from judging a 20-year track record that's clear to a shorter track record at a different firm and then have to supplement that by trying to judge someone's character."

The trend toward smaller funds has economic ramifications that are driving another round of departures from the biggest outfits. Venture firms typically collect 2 percent of each fund as a management fee -- but 2 percent of $400 million is much less than 2 percent of $1 billion. "You can't support a 30-person staff on today's funds; you have to go back to the old model of a few partners, one or two associates and an analyst," says Meyer.

Battery Ventures, for instance, ramped up its staffing during the boom times and by 2001 had 60 partners and employees, says Tom Crotty, a general partner. "That was what we needed to support a $1 billion fund," he adds. But Battery's next fund will be more like $450 million -- and sure enough, Battery has been wielding the axe. Head count at the firm has fallen to 40, and five of the general partners have left. Firms are cutting back in other ways: Waltham-based Atlas Venture shuttered two of its satellite offices, in Seattle and San Francisco, while Lexington, Massachusetts­based Highland Capital Partners closed its San Francisco office (although it retains an outpost in Bethesda, Maryland.)

One of the more conspicuous departees in the latest Silicon Valley shakeout is Bill Burnham, who left Palo Alto­based Mobius Venture Capital this spring. The former star Internet analyst in Frank Quattrone's high-powered technology investment banking franchise at Credit Suisse First Boston, Burnham, then only 28, quit CSFB in late August 1999 to move to Mobius's precursor, Softbank Venture Capital. Silicon Valley sources say that he is now talking to smaller venture firms.

Limited partners greet the exodus with mixed emotions. On the one hand, they are pleased to see venture fund managers behaving prudently. "The tone of our annual meeting with limited partners this year was a lot friendlier," says Battery Venture's Crotty. The new fund? "It's already oversubscribed, and we haven't even started asking for money yet." On the other hand, limited partners recognize that the cutbacks have a downside.

"The sense is that the number of good investment opportunities is increasing, that the amount of cash available to invest is increasing," points out Jonathan Axelrad, chairman of the fund services group at Silicon Valley law firm Wilson Sonsini Goodrich & Rosati. "If there turns out to be a shortage of anything in the future, it could be people." While new cash can arrive almost instantaneously in response to new opportunities, it takes time for a new venture partner to understand the business of seeding start-up companies and to be integrated into a firm. "There is a risk here that there will be more money than there are experienced and qualified venture investors, because of the departures," says Paul Koontz, a general partner at Foundation Capital in Menlo Park, California. "You simply can't staff up quickly; it's not an assembly line."

Industry veterans are also uneasy about the growing amount of specialization, represented not just by Alta Partners' decision to separate out its life sciences fund with the goal of creating a stand-alone vehicle down the road but also by the firm's division into two life sciences funds dedicated to early- and late-stage investments. Funds of funds like the trend because it allows them to pick and choose from among the available funds and build a diversified portfolio of very different, uncorrelated venture funds. "Some people thought Tallwood Venture Capital would be too limited because it focused only on semiconductor-related deals, but we think that's fine -- that's where they have the expertise, and they are sticking to it," says Clinton Harris, founder and managing partner of Grove Street Advisors, a fund of funds based in Wellesley, Massachusetts.

One of a handful of funds focused solely on semiconductors, Tallwood is run by founder Diosdado Banatao, who combines venture investing skills with corporate operating experience: He founded two semiconductor companies (including Chips & Technologies, which he sold to Intel in 1997). Few venture investors, however, have Banatao's unusual mix of skills, the kind that can induce limited partners to invest in such a narrowly focused technology fund.

Specialization poses other risks. For instance, the current emphasis on life sciences causes some industry participants to fret that another valuation bubble may be taking shape in an industry that is notoriously volatile and subject to a great deal of regulatory and political risk. "If anything, life sciences funds are now overfunded relative to IT, but the buzz is just growing," Grove Street's Harris says. Within information technology, similar fears are voiced about the number of new nanotechnology, social networking and security software companies being funded.

Still, if it's any reassurance, the pace of revival in venture capital activity thus far is patient and even cautious by past standards. Investors are doing more due diligence and haggling more over terms. "A private-placement memorandum used to be a page or two long; now you get them an inch thick," says attorney Axelrad. Another encouraging sign that the prudence born of the last bubble persists is that a number of firms are finding it hard to raise capital. "I've seen groups that have been in and out of the market intermittently over the past two years, and they're still trying to raise the same fund," says one limited partner. "But I'm still worried, because while even the new money is hanging back and waiting for the quality funds to come into the market, at some point that may change."

Adding to the potential funding frenzy is the arrival of European institutional investors like InterWest's would-be limited partner from Switzerland. Over the past three years, sovereign rules restricting private equity investments outside Europe have been relaxed, most recently in Finland. "There's a risk that these guys could turn out to be the straw that broke the camel's back: They're inexperienced -- they may be hot money dashing in and out of the sector," notes a fund-of-funds manager who says he has fielded "perhaps 30 or 40" requests to invest in his fund. He has turned them down -- "We want solid, knowledgeable investors" -- but now worries that these investors will forge ahead and invest money with smaller wanna-be funds. And money invested at the top of the venture capital financing pyramid has a cascade effect: Newly flush firms are eager to put that cash to work and drive up valuations. Thus another boom is born.

That's something that even the new generation of venture investors dreads. "I want to run this business the way venture capitalists did 25 years ago by building businesses, not running a portfolio," says David Fialkow, a co-founder of Cambridge, Massachusetts­based General Catalyst Partners. Half of the deals he backs are proprietary, meaning that there's no opportunity for rival venture firms to bid up valuations, and he isn't worried that there have so far been no exits from General Catalyst's first fund, raised in 2001. "There's no such thing as overnight success, grand slams and home runs; just slowly, painstakingly building stable, strong, growing businesses," he explains. The eager hordes of venture capital investors should pray that Fialkow and his peers cling to that discipline this time around.

A new guard rises

It's known only by its working title -- Project Shasta -- and hasn't raised a dime yet, but the new venture capital firm formed by three senior-level refugees from top-tier venture firms is generating a lot of buzz in Silicon Valley. "Everyone wonders how much these guys are going to nail down -- $100 million? $200 million? More?" says one venture capitalist.

The three partners behind Shasta -- Robert Coneybeer (formerly of New Enterprise Associates), Tod Francis (Trinity Ventures) and Ravi Mohan (Battery Ventures) -- carry a lot of clout. Over the past decade the trio say that they have turned $400 million of capital into $1.2 billion for investors in their prior funds.

Now they are opening their own shop. "We see technology going through a big evolution as the consumer starts to drive innovation, and we'll be focusing on that as an exciting new area," says Francis. "We're very motivated, very hungry."

Francis and his partners are launching exactly the kind of fund that many institutional investors are seeking: a fledgling venture capital partnership managed by seasoned hands. "There's no doubt that someday we'll be talking about at least a handful of the venture firms being founded today with the same kind of hero worship that we reserve now for legendary firms like Kleiner Perkins Caufield & Byers," says Thomas Beaudoin, a partner at Boston-based law firm Testa, Hurwitz & Thibeault, which has a number of venture capital clients.

The problem, of course, is separating the winners from the losers. The risk of backing a bunch of single-fund underperformers kept pension funds and college endowments away from emerging managers until now, when suddenly these investors find themselves unable to place as much as they want with top-tier firms. Making a virtue of necessity, a growing number are investing part of their venture capital allocations with emerging partnerships, hoping to get in on the ground floor of the next superstar firm.

"Limited partners have found themselves needing to deploy more capital just as the number of interested investors is rising and as existing partnerships are downsizing the funds they are raising," says Anthony Romanello, director of investor services at Thomson Venture Economics, which monitors venture capital investors. He adds that many of the emerging groups include partners from top-tier firms "who know who within the LP world to go to." Public pension funds, he notes, will be among the first to move into the emerging-manager arena because they were slower than corporate pension plans or university endowments to allocate funds to venture partnerships.

Christopher Ailman, chief investment officer of the $114 billion California State Teachers' Retirement System, says that his pension fund's clout "generally" means that it hasn't been denied access to top-tier funds but that "we are limited in the amount that we can invest" as general partners cut back fund sizes. So Ailman plans to put up to $100 million of CalSTRS's $5.5 billion private equity allocation in emerging venture capital managers during the current fundraising wave.

"We started seeing some talented younger managers spinning out of established funds to set up their own shops, and we wanted to make our capital accessible to some of these small funds," Ailman says. "We don't want to sacrifice return just to put the money out."

The number of new funds run by emerging managers -- defined by most as experienced investors launching their first independent funds -- is growing rapidly. Thomson Venture Economics estimates that 52 "maiden" venture firms have closed on their inaugural funds since January 1, 2003.

Many of the emerging-manager funds include familiar names. Fred Wilson, formerly a partner at New York­based Flatiron Partners, one of the first Silicon Alley funds, teamed up with Brad Burnham, who previously headed AT&T's venture capital arm, to form Union Square Ventures only a few blocks from Flatiron's former office. Terry Garnett from Venrock Associates and David Helfrich of ComVentures have joined forces to launch Garnett & Helfrich Capital, a midmarket technology buyout fund (see People).

One of last year's hottest new funds came from a Stanford University­trained Silicon Valley electrical engineer with little experience as a venture investor: Diosdado Banatao raised $180 million for Tallwood Venture Capital from Stanford and Harvard universities, among other investors, to invest in semiconductor-related start-ups. "The sizzle was concentrated in this one guy, who has an incredible track record in building companies," says Clinton Harris, founder and managing director of Wellesley, Massachusetts­based Grove Street Advisors. "People were flinging money at them, eager to invest." Banatao, a native of Cagayan Province in the Philippines, has launched three tech companies of his own -- including one he sold to Intel Corp. -- and start-ups in his Tallwood portfolio have been snapped up by Broadcom Corp., Ciena Corp. and Cirrus Logic.

Harris believes that backing emerging managers is a no-brainer. "If you believe you are able to identify top-quartile groups, you can do it from the beginning of their lives," he contends.

To many endowments and other institutional investors eager to put cash to work, the logic of venture investing is compelling, no matter the dangers. Says the chief investment officer at one large academic institution, "We think we can do enough due diligence to manage the risks that always attach to venture investing."

Other investors remain reluctant to play talent scout with emerging managers. "It's a crapshoot," declares Kevin Delbridge, managing director of HarbourVest Partners, a private equity firm in Boston. Potential investors face a big due diligence hurdle, he warns. "It's hard enough identifying today's star managers; picking tomorrow's is damn near impossible." -- S.M.